When trading shares and other financial instruments in an automated exchange, both buyers and seller of course want to get the best possible price. A seller of a particular financial instrument is interested in getting a high price, whereas a buyer is interested in getting a low price.
The price is determined by the market. Thus, the price is likely to go up if there are many sellers and few buyers of a particular financial instrument at a particular price, and vice versa.
Sometimes a seller or buyer may want to sell/buy a large volume of a particular financial instrument. If the order having the large volume was to be placed in the market as one single order, there is a great likelihood that there would be a negative impact on the market. Thus, the price for that particular financial instrument changes in a direction not wanted by the seller/buyer placing the order having the large volume. See also Schwartz et al: “Next-generation securities market systems: An experimental investigation of quote-driven and order-driven trading”, Journal of Management Information Systems, vol 14, no 2, pp 57-79, 09 1997, ISSN 0742-1222.
In order to reduce the impact on the market, it is common that the seller places his selling order in small bits or fractions. In this way only a fraction of the total volume of the order is displayed at each instant. The rest of the order is thus hidden from other investors, and the order is usually referred to as an order having a “hidden volume”. When the whole first fraction has been traded, a second fraction having the same volume as the first fraction is generated and displayed. This pattern is repeated until the entire volume of the order has been traded.
In an automated exchange system, there are two main ways of placing orders having a hidden volume. A first way is to manually only enter a small fraction at the time of the order into the automated exchange and wait for that first fraction of the order to be traded before entering the next fraction. The second way is to provide functionality in the automated exchange system that enables trading with a hidden volume in an electronic market. In the second case, the investor enters his order in a conventional way but at the same time he instructs the automated exchange system to handle the order as an order having a hidden volume and also specifies the fraction size. The automated exchange then only displays a fraction of the order at the time, and when the first fraction is traded, the exchange system automatically displays a second identical fraction of the order etc. However, since this is a known way of trading an order having a large volume in an automated exchange other investors are aware that orders having a hidden volume exist. Therefore, when investors observe the behavior of other investors, they can quite easily spot an investor trading an order having a hidden volume, since a new order having the very same size is generated when the first order is traded, although they cannot know the total volume of the order.
However, since this is a known way of trading an order having a large volume in an automated exchange other investors are aware of that orders having a hidden volume exist. Therefore, when investors observe the behavior of other investors they can quite easily spot an investor trading an order having a hidden volume, since a new order having the very same size is generated when the first order is traded, although they cannot, know the total volume of the order.
The fact that others can detect an order having a hidden volume reduces the positive effect of trading an order with a hidden volume, and the market impact can become significant.